Report to Detail Subprime Underside

By

Liz Rappaport,

Carrick Mollenkamp And

Serena Ng

Updated April 2, 2011 12:01 a.m. ET

A report by a Senate subcommittee investigating the subprime implosion is likely to cast a harsh spotlight on Wall Street's mortgage machine and detail bad blood between Goldman Sachs Group Inc.GS-1.03% and Morgan StanleyMS-1.17% over one of the most controversial pools of bonds, according to people familiar with the report.

The Senate Permanent Subcommittee on Investigations is expected to release the report soon, and the panel's findings are expected to include previously undisclosed emails obtained from securities firms that developed, sold or bet on subprime mortgages and financial vehicles such as collateralized debt obligations, or CDO. A CDO is an investment backed by a pool of mortgage bonds, loans or other assets.

People familiar with the matter said Goldman and Deutsche Bank AG are expected to draw much of the scrutiny in the Senate report. Both of those firms have been criticized for sometimes creating securities and selling them to one set of investors, while advising others to bet against them.

A spokesman for the German bank said it is waiting to review the report before it decides whether to comment on the conclusions. A Goldman spokesman declined to comment on the report. A Senate Permanent Subcommittee spokesman declined to comment.

In addition to a new round of public embarrassment, emails and other documents that are expected to be released by the subcommittee could expose Wall Street firms to more litigation over their behavior before and during the crisis. The report also is likely to include new facts about mortgage-related bets and losses by firms such as Morgan Stanley, according to people familiar with the situation.

Last year, Goldman Chief Executive Lloyd Blankfein and other executives at the New York company faced tough questioning from lawmakers on the subcommittee about whether Goldman placed its own interests ahead of clients. After an eight-month review, Goldman announced in January a total of 39 changes to reduce conflicts with clients and enhance its disclosures of financial information.

The coming report is likely to be much more detailed than aspects of the Senate probe that were made public last year. The panel, led by Sen. Carl Levin (D., Mich.), held hearings on the role that ratings firms and lenders such as Washington Mutual Inc. played in the financial crisis.

The report is likely to zero in on financial vehicles such as the ones Goldman created in 2006 and 2007 as it became more worried about its exposure to the U.S. housing market. The Senate subcommittee scrutinized a CDO called Hudson Mezzanine Funding 2006-1 for evidence that Goldman created pools of bonds to make large bets against the housing market aimed at shielding the firm from losses, even as it underwrote similar debt pools for clients and actively sold bullish positions in the CDOs to institutions that didn't expect the housing market to sink.

In the Hudson deal, Goldman sold credit insurance on the $2 billion CDO, meaning that if the loans backing the deal began to default, Goldman would make money. To make the deal work, though, someone else had to be on the other side of the trade. That counterparty has remained a mystery since the deal was done in the fall of 2006.

The Senate report is expected to disclose that Morgan Stanley, one of Goldman's biggest Wall Street rivals, was a large counterparty in the Hudson deal, according to people familiar with the matter. Morgan Stanley made about $1.2 billion in bullish bets on Hudson, while helping Goldman choose the bonds underpinning the deal, these people said. Morgan Stanley declined to comment.

After the housing bubble burst, the top-rated slices of the CDO were downgraded to "junk" levels, causing their value to plunge. Goldman issued margin calls to Morgan Stanley, demanding that the firm put up cash to cover its losses, people familiar with the situation said. Morgan Stanley rejected the margin calls as too high.

The dispute escalated to the highest levels of the two companies, with Goldman President Gary Cohn defending the firm's valuations, these people said. The Hudson deal was one of the bad mortgage bets that forced Morgan Stanley to record a $9 billion trading loss in 2007.

In 2008, Morgan Stanley came close to filing a lawsuit against Goldman over its role as liquidation agent in the Hudson deal, according to people familiar with the situation. The CDO was being liquidated because defaults on the bonds underpinning the CDO piled up and the deal became too damaged to pay its investors. Lawyers for Morgan Stanley drafted a suit but never filed it in court, said the people.

Morgan Stanley alleged that the Hudson agreement didn't allow Goldman to decide when to liquidate, according to a synopsis of the draft suit written by Goldman's lawyers that was reviewed by The Wall Street Journal. Morgan Stanley believed Goldman was obligated to liquidate when certain triggers were hit, the draft suit said. The draft alleged that the foot-dragging over the liquidation helped Goldman because the firm was shorting the assets in the CDO, or betting they would go sour. The delays hurt Morgan Stanley, which was betting the assets would hold their value, the draft said.

Morgan Stanley claimed it had an agreement in the deal that the Hudson liquidation would be "mechanical" and like "clockwork," the draft suit said.

A person familiar with Goldman's involvement in the deal said the firm realized it was in a potentially conflicted role as both liquidation agent and holder of the largest negative bet on Hudson. Goldman tried to offer the job of liquidator to another firm, as it did for four other CDOs, this person said. But Morgan Stanley rejected the idea because of the time needed for a new agent to liquidate the CDO, the person said.

Goldman's lawyers believed that the draft lawsuit by Morgan Stanley had no merit because no other Hudson investors objected to the liquidation, according to the synopsis. Goldman also claimed that the Hudson documents gave Goldman the power to use its discretion when liquidating the CDO, including a 12-month period to do so, according to the synopsis.

Executives at Goldman have said numerous times, including at last year's hearing by the Senate subcommittee, that the firm made deals like Hudson in order to bet against the housing market after the firm decided it had too many bullish bets on housing.

Goldman's mortgage division lost $1.2 billion in the two worst years of the crisis, 2007 and 2008, according to the company.

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